My Thoughts on Gold

One of my favorite bloggers, Miserly Bastard, has posted recently on why he thinks gold is a bad investment. His post has inspired me to write about why I think gold is a good investment.

Readers of my old blog know that I am somewhat of a gold bug. I have been playing around in gold stocks, options, and futures (with disastrous results) for at least three years. By no means am I a doom and gloom guy, but I think that the arguments for owning some gold are very compelling. To frame my thinking on gold, I like to think of it as both a currency and an investment:

As a currency gold is

  • The world’s oldest currency and store of value
  • Impossible to create without digging it out of the ground – unlike Diamonds, real gold cannot be made in a chem lab
  • Hedge against a falling USD and fiat currencies in general
  • Hedge against inflation
  • Gold pays an attractive and tax-defered yield (this is a leap of faith but I consider it to be true because of the contango in gold futures)


As an investment:

  • Very strong demand for gold jewelry in India and China
  • Asian central banks hold a tiny percentage of their reserves in gold. Any meaningful change in this policy will present a huge upward force to the gold price
  • Gold bugs have a somewhat religious fervor for gold. If gold prices decline, there are lots of eager buyers

MB argues that the main reason he would own gold would be to protect against extremely unlikely economic situations “namely high inflation and/or rapidly weakening fiat currency.”

I don’t think either of these situations is extremely unlikely, in fact I think we’re experiencing them now and will continue to for some time. The government claims that inflation is 2% on an annualized basis. In my opinion, this number is a joke – the government cooks up the lowest possible number that they can reasonably get away with. Also, it’s in the government’s interest to have real inflation running at a much higher rate than reported inflation: it minimizes inflation-linked payments (Social Security & TIPS for example) and shrinks the real size of the outstanding debt.

As for MB’s second point, fiat currencies (especially the USD) have been weakening against hard assets for years. The forces causing this are secular in nature.

5-year-gold-chart.jpg

 

How I own gold:

In my medium-term cash management account, I keep about 20% invested in GLD. GLD is an ETF which holds a pile of gold in a warehouse somewhere.

As an investment/speculation I own gold stocks: GDX and AAUK. Gold mining companies can do really well when the price of gold rises but it’s not a guarantee. Lately, the cost of mining gold has risen, causing profit margins to fall.

My total exposure to gold is less than 10% of my networth.

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7 Responses to My Thoughts on Gold

  1. dave says:

    “Gold pays an attractive and tax-defered yield (this is a leap of faith but I consider it to be true because of the contango in gold futures”

    Admittedly I don’t understand what contango has to do with the tax- defered yield? I tried googling around to find out more but couldn’t.

    Great Post- I miss gold

  2. Will says:

    Hey Dave — yes, it’s about time gold made a comeback on this blog! Everytime gold goes above $700 I get crazy!

    Anyway, I’m glad you asked the question about contango/tax-deffered yield. It should be the subject of a fresh post but I’ll take a quick stab at it here.

    Contango is a term used to describe an upward sloping price curve in the futures market. In other words, the price of the commodity/futures contract goes up the further down the road you get. For example, the October ’07 Comex Gold Contract is selling for $709 while the October ’08 contract goes for $746.6.

    Theoretically, you could buy 100 ounces of gold at the spot price, sell 1 futures contract at $746.6 and lock in a return of 5.3%. This wouldn’t be feasible with only 100 ounces because storage costs, insurance, and commissions would easily kill the return.

  3. Destry says:

    I wanted to mention that Gold can be synthesized both in a particle accelerator and also in a nuclear reactor. Both can transmute isotopes of mercury into highly pure gold.

    But don’t worry, such methods are not cost effective. 🙂

  4. Will says:

    Hi Destry — thanks for the comment.

    Just how cost ineffective is this process? How does it work? Any chance it will become cheaper in future?

  5. Ames Tiedeman says:

    Gold will go way up, maybe to $1,500 an ounce or higher because the dollar will fall for years. The dollar will keep falling and here is why:

    The U.S. cannot sustain 800 bilion a year trade deficits. We cannot export our way out of this mess. The only answer is a sharply lower dollar to drive manufactruing home and to lower the trade deficit. The dollar has much farther to fall. What you are seeing is a long term effort (it will take 20 years) to get the trade deficit back under 1% of GDP. We are currently running a trade imbalance of nearly 6% of GDP. No nation can do this. The IMF would be stepping in to help any nation if its trade imbalance went to 6% of GDP becuase its currency would collapse! The U.S. is different, but still, we cannot sustain a trade deficit of this magnitude. People must understand that when we buy an item from say China, we pay in dollars. The Chinese company we just bought from them goes to an Exchange Bank in China and converts those dollars to Yuan. The Chinese banking system (Chinese Government) is now sitting on those dollars. They can either 1, buy oil, 2, buy Treasuries, 3. buy U.S goods, 4. buy U.S. Corporations, 5. other. Over time if we (the U.S. ) continue to run a trade deficit we could simply be completely bought and controlled by foreigners. Warren Buffet has explained the situation as being like a rich Texas farmer who loses a small piece of his land year after year and never notices for a while. When he then notices, tragedy sets in because he no longer controls his land. So in sum, we need to get the trade deficit way down. This is why the Fed has abandoned the dollar. It wil be going down for the next 20 years. That is how long it is going to take to correct this imbalance mess. Bottom line: Lower, much lower dollar will equal higher inflation and higher GOLD prices. Much higher!

  6. […] MB Changes His Mind on Gold Back in September 2007, Miserly Bastard wrote a post — My Thoughts on Gold — in which he outlined reasons why he thought gold was a bad investment.  I responded here with my thoughts on why gold is a good investment. […]

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